Who Are the Owners of an LLC?
A lender took an assignment of a 25% interest in an LLC in exchange for the lender’s cancellation of the LLC’s debt, but the lender was never admitted as a member. Later the lender agreed to sell his “25 percent ownership interest,” but his buyer defaulted and claimed that the lender did not have an ownership interest in the LLC.
Ownership of property is covered in a first-year law school class because it is a fundamental legal concept, but sometimes the application of even fundamental concepts can be troublesome. In this case the Kentucky Supreme Court overruled the Court of Appeals and held that in the context of an LLC, “ownership” and membership in the LLC are synonymous – that the owner of an economic interest in the LLC does not have an “ownership interest” if he is not admitted as a member. Spurlock v. Begley, No. 2009-SC-000050-DG, 2010 Ky. LEXIS 80 (Ky. Apr. 22, 2010).
Tate Begley loaned $75,000 to Caribou Coal Mining Processing, LLC (Caribou), in exchange for Caribou’s promissory note. The note was unpaid and went into default. Robert Griffin, the founder of Caribou, orally promised to give Begley a 25% interest in Caribou in exchange for the $75,000 debt. Begley and Ben Spurlock then entered into a one-paragraph written agreement (Sale Agreement) in which Spurlock agreed to pay Begley $70,000 in exchange for Begley’s “25 percent ownership of Caribou Coal Processing LLC.” Spurlock, 2010 Ky. LEXIS 80, at *8.
A year later Caribou was insolvent and had ceased operations, and Begley sued Spurlock for non-payment on the Sale Agreement. Spurlock defended on the grounds of failure of consideration, contending that Begley did not hold an ownership interest in Caribou. At trial the jury found that Griffin had indeed transferred a 25% ownership interest to Begley and ruled for Begley on his Sale Agreement with Spurlock. The Court of Appeals affirmed.
The Kentucky LLC Act uses the term “members” rather than “owners,” as do most other state statutes. Ky. Rev. Stat. § 275.015(16). If there is no written operating agreement, a person acquiring an interest directly from the LLC becomes a member only if all members consent in writing, and a person acquiring an interest by assignment from a member becomes a member only if a majority in interest of the members consent in writing. Ky. Rev. Stat. §§ 275.275(1), 275.265(1).
If the assignee is not admitted as a member, the membership interest becomes divided. The economic rights are held by the assignee and the governance rights are retained by the assignor, who continues to be a member. Ky. Rev. Stat. § 275.255(1)(d). If the members consent and the assignee is admitted, the transfer of the membership interest conveys both the economic and the governance rights. Spurlock, 2010 Ky. LEXIS 80, at *7.
After reviewing the Act’s provisions, the court concluded:
This, then, leads to the conclusion that simply acquiring economic rights does not, in and of itself, equate to “ownership” or “membership” in the limited liability company.
. . .
… In the context of limited liability companies, “ownership” and “membership” are synonymous.
Id. At *7-8. The court then reasoned that because Begley acquired only an economic interest and was not admitted as a member, he did not acquire an ownership interest in the LLC. Spurlock therefore had a valid defense of failure of consideration under the Sale Agreement.
The court’s analysis makes sense if one understands “ownership” in the sense of “[t]he complete dominion, title, or proprietary right in a thing or claim.” Black’s Law Dictionary 1260 (4th ed. 1968). After all, Begley did not have all of the rights of a member – he had the economic rights but not the governance rights. And if the word “membership” is used only for a person who is both admitted as an LLC member and who holds all of the associated economic rights, then the court’s conflating of ownership and membership is correct.
But as the Spurlock court itself pointed out, a member who transfers its economic interest to a non-admitted assignee continues to be a member even though it has no remaining economic rights. Presumably the court would not have found Begley to have “ownership” if he had been admitted as a member but had assigned his interest to a non-admitted assignee, leaving Begley a member holding governance rights and no economic interest. In that scenario, LLC membership would not equate to ownership.
More careful drafting of the Sale Agreement could have changed the result in this case. If the Sale Agreement had referred to an “economic interest” or simply an “interest,” rather than an “ownership interest,” or if it had included language otherwise clarifying that Begley had not been admitted as a member, then Spurlock would have had no defense. The court did not examine the intent of the parties; it simply construed any ambiguity in the phrase “ownership interest” against Begley because he drafted and prepared the Sale Agreement. Spurlock, 2010 Ky. LEXIS 80, at *8-9..
The court also could have been more careful with its language. Its generalized equating of “ownership” and “membership” reaches too far by ignoring the fact that an LLC can have a member with no economic interest. Words are slippery and should be used carefully. The question, as Humpty Dumpty said to Alice, is which is to be master, the words or their speaker.
Time Is Running Out to Defer Income Recognition from Debt-Equity Exchanges
Restructures of financially distressed firms often involve debt-equity exchanges. The concept is straightforward: the company issues equity to its lenders in exchange for their cancellation of some of the company’s debt. The company’s debt burden and interest payment expenses are reduced and its balance sheet is strengthened.
On the downside, the company’s equity holders are diluted, often substantially. The alternative to the restructure, of course, may be a chapter 7 bankruptcy in which the equity owners are wiped out. Lenders don’t usually want to take equity in their debtors, but depending on its security position, a lender may view a debt-equity exchange as a preferable alternative to liquidation or as a necessary component of a chapter 11 case. The exchange will provide the lender with upside on the equity it receives, assuming the company survives and ultimately prospers.
The details of a debt-equity exchange are complex. Multiple classes of debt and equity may be involved. The company and the debtors will need to agree on valuations of different classes of debt and equity, on how much debt and how much equity to exchange, and on the classes and amounts of equity to be exchanged. And as with any major corporate transaction, the tax consequences have to be considered.
If the amount of debt that is cancelled exceeds the fair value of the equity issued in exchange for the debt, the company will recognize cancellation of debt (COD) income in the amount of the excess. I.R.C. § 61(a)(12), § 108(e)(8). If the debtor is an LLC, the equity may consist of either a capital or a profits interest in the LLC.
The Code provides several exceptions to recognition of COD income, including an insolvency exception. If the company issuing the equity is insolvent or in a title 11 bankruptcy case immediately before discharge of its debt, it will not recognize COD income. I.R.C. § 108(a). The tax obligation is deferred and not completely eliminated, because what would otherwise be COD income is applied to reduce several of the company’s tax attributes, beginning with its net operating loss carryovers. I.R.C. § 108(b).
The tax rules on debt-equity exchanges apply to corporations and to LLCs in the same way, with one significant exception. LLCs are taxed as partnerships and LLC income is passed through to the members. COD income of an insolvent LLC will therefore be allocated to the members, but they cannot use the § 108 insolvency exception based solely on the LLC’s insolvency. The members have the income, but the LLC has the insolvency. Not unless the member itself is insolvent can it claim the insolvency exception.
In many cases the member will not be insolvent, in which case the LLC’s COD income will be included in the member’s income unless any of several other exceptions apply to that member. And if the LLC is insolvent, there won’t be any cash distributions to the members to cover their tax bill from the COD income.
LLC members caught in this situation may be able to defer COD income from a debt-equity exchange, if the exchange occurs before the end of this year. The American Recovery and Reinvestment Act of 2009 added a new Code § 108(i), which allows taxpayers incurring COD income as a result of debt-equity exchanges occurring during 2009 or 2010 to elect to defer that income.
The deferred income will be included in the taxpayer’s income ratably over five years, starting in 2014 and ending in 2018. The deferral election is made by attaching a statement to the taxpayer’s return for the taxable year in which the debt-equity exchange takes place. The deferral is accelerated into any year in which the taxpayer’s death, sale of the LLC interest, or cessation of doing business occurs.
The deferral will be attractive for most LLC members receiving COD income. Whether it’s the right choice will depend on the taxpayer’s individual situation, and on what happens to income tax rates during 2014 through 2018.
But the clock is running down on this deferral opportunity. If an LLC restructures with a debt-equity exchange that closes after December 31, 2010, its members will no longer be able to elect the deferral. As the end of 2010 approaches, LLCs contemplating debt-equity exchanges should consider timing the transaction to ensure closing before the year end, in order to preserve the members’ ability to elect the deferral.
